Though complex, rep and warranty insurance use is growing

For years, I listened to insurance brokers market a product called rep and warranty insurance, which they said would help get deals done. During this time, I had clients consider it, but ultimately they didn't buy it. It seemed nobody wanted to be the first or only one using this new product. Today, however, this insurance is fast becoming a valuable deal tool.

For background and to simplify: Reps and warranties in mergers and acquisitions are sellers' promises about the business being sold. If those promises turn out to be inaccurate, buyers don't want to chase sellers after closing to recover their damages. Consequently, depending on the type of deal, sellers are often required to place some of the purchase price in escrow at closing to give buyers an accessible pot of money to seek recovery.

Depending on the deal, the escrow may be the only source of recovery (typically called an “escrow only” deal) or the sellers may be on the hook for amounts greater than the escrow, typically up to an agreed cap.

In the escrow only deal, buyers may not be comfortable with the size of the escrow. In a deal with a gap between the escrow and the cap, buyers may not be comfortable they can find and collect from sellers after closing. This is particularly true when sellers are private equity funds at the end of their life cycle or individual sellers. Rep and warranty insurance has become a way for buyers to get protection they want but don't get from sellers.

At Jones Day, we've now had a chance to see rep and warranty insurance in action. The good news is some insurers move quickly to complete their diligence and get the paperwork in place. Also, buyers seem to think the product is reasonably priced for the coverage provided, and sellers often will pay the premium rather than tie up more money in escrow. The not-as-good news is that the insurance can be quite complex, particularly in operation.

Here are some issues to consider:

The policy is a separate contract from your purchase agreement and is negotiable with the insurer. Terms and exclusions differ among insurers, so shop around for terms, not just rates. Don't assume you will get the same coverage under your policy that you negotiated with seller. For example, even if you can recover consequential damages under your purchase agreement, insurance companies will not insure them.

In operation, the policy must be viewed in tandem with the purchase agreement. For example, if you pursue fraud claims against sellers to eliminate indemnity limits, you could, depending on the policy's exclusions, undermine your insurance claim. Also, be sure you understand the insurance company's defense, settlement and subrogation rights under the policy before you assert or try to settle an indemnity claim under the purchase agreement. Again, you don't want these actions to undermine your insurance claim.

Finally, remember that insurance covers unknown liabilities. There is no coverage for items scheduled as exceptions to the reps and warranties. Also, be mindful that third-party reports from lawyers, accountants and consultants will be reviewed and the contents likely excluded from coverage. Thus, there is no reward for the “throw everything in but the kitchen sink” style of reporting.

Rep and warranty insurance is now a viable tool in the M&A toolkit. While it can be a relatively quick and affordable way for a buyer to get protection a seller can't or won't give, there are traps for the unwary that require insurance and M&A expertise to work around.

Denise Carkhuff is a partner at Jones Day. She has more than 17 years of merger and acquisition experience with a focus on private equity.